The Great Depression as a Credit Boom Gone Wrong

April 19, 2012

“When the market rate fell below the natural rate, Mises and Hayek argued, prices rose and investment boomed. The source of that divergence, according to Mises, was the banking system, freed from the disciplining influence of the classical gold standard. Excessive credit creation by banks, both central and commercial, encouraged asset price inflation, fueling consumption and investment. The longer that asset-price inflation was allowed to run, the greater were the depletion of the stock of sound investment projects and the accumulated financial excesses.”

“Moreover, the more severe became the subsequent downturn. The credit boom thus contained the seeds of the subsequent crisis. The policy implication was that countries should avoid monetary arrangements that allowed significant divergences between the market and natural rates of interest (in particular, a gold standard of the rigid prewar variety was preferable to the more malleable interwar vintage) and that they should allow the downturn to proceed in order to purge unviable firms and investment projects from the economy, thereby clearing the way for sustainable recovery.”

You won’t hear this interpretation from Mr. Bernanke, as it would mean the Federal Reserve – through distorting the price and quantity of credit – contributed to the Great Depression. Instead, you will hear the Gold standard prevented the bubble from growing perpetually; that is, if the Federal Reserve had been allowed to flood the country with still more credit (US dollars are promissory notes), the bubble could grow infinite in size.

Notice how we have a similar setup to the early to middle stages of the boom bust cycle: interest rates are being held below the inflation rate, which will have the effect of creating another bubble, and bust. This time, the bubble is fiat paper, government bonds, and left unchecked – corporate bonds too. Pegged rates hide risk, create misallocations of capital, and help blow bubbles.